Chapter 17

Banking and the Management of Financial Institutions

Chapter Preview
Banks play an important role in channeling funds (about $6 trillion annually) to finance productive investment opportunities. They provide loans to businesses, finance college educations, and allow us to purchase homes with mortgages.

http://www.youtube.com/watch?v=BvM4erYTucQ

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Chapter Preview
In this chapter, we examine how banking is conducted to earn the highest profits possible. In the commercial banking setting, we look at loans, balance sheet management, and income determinants. Topics include:
The Bank Balance Sheet Basics of Banking General Principles of Bank Management Off-Balance Sheet Activities Measuring Bank Performance
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Chapter Preview
Asset/Liability Management is a central function of banks. It impacts:
Bank profitability Credit Risk Interest rate Risk Liquidity Risk

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Income Statement
Interest Income Provision for Loan Losses Interest Expense Net Interest Margin Non-Interest Income Operating Expenses G/L on Securities and Extraordinary 548.0 -25.5 -263.1 259.4 217.4 -290.2 1.3

Pre-tax Income
Income Taxes Net Income

187.9
-59.5 128.4
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Banking Business Models

Return on Assets (ROA)

0.60%

1.20%

1.65%

Capital Ratio

4.00%

8.00%

11.00%

Leverage Ratio

25

12.5

9.1

Return on Equity (ROE)

15.00%

15.00%

15.00%
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The Bank Balance Sheet

The Balance Sheet is a list of a banks assets and liabilities Total assets = total liabilities + capital

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The Bank Balance Sheet

A banks balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets) Banks invest these liabilities (sources) into assets (uses) in order to create value for their capital providers

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The Bank Balance Sheet

The next slide shows the aggregate balance sheet for all commercial banks as of 2007. We will then step through each item, discussing each in detail.

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The Bank Balance Sheet

Flow of funds (tab down to commercial banks) http://www.federalreserve.gov/releases/z1/ 17-10 current/z1r-4.pdf

The Bank Balance Sheet: Liabilities (a)

Checkable Deposits: includes all accounts that allow the owner (depositor) to write checks to third parties; examples include non-interest earning checking accounts (known as DDAs demand deposit accounts), interest earning negotiable orders of withdrawal (NOW) accounts, and money-market deposit accounts (MMDAs), which typically pay the most interest among checkable deposit accounts

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The Bank Balance Sheet: Liabilities (a) Checkable deposits are a banks lowest cost funds because depositors want safety and liquidity and will accept a lesser interest return from the bank in order to achieve such attributes. They also make up about 4% of bank liabilities.

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The Bank Balance Sheet: Liabilities (b) Nontransaction Deposits: are the overall primary source of bank liabilities (74%) and are accounts from which the depositor cannot write checks; examples include savings accounts and time deposits (also known as CDs or certificates of deposit)

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The Bank Balance Sheet: Liabilities (b) Nontransaction deposits are generally a banks highest cost funds because banks want deposits which are more stable and predictable and will pay more to the depositors (funds suppliers) in order to achieve such attributes.

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The Bank Balance Sheet: Liabilities (c)

Borrowings: banks obtain funds by borrowing from the Federal Reserve System, other banks, and corporations; these borrowings are called: discount loans/advances (from the Fed), fed funds (from other banks), interbank offshore dollar deposits (from other banks), repurchase agreements (a.k.a., repos from other banks and companies), commercial paper and notes (from companies and institutional investors)

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The Bank Balance Sheet: Liabilities (c) Certain borrowings can be more volatile than other liabilities, depending on market conditions. They currently make up about 12% of bank liabilities, but have been as high as 26% (2004) and as low as 2% (1960) in recent history.

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The Bank Balance Sheet: Liabilities (d) Bank Capital: is the source of funds supplied by the bank owners, either directly through purchase of ownership shares or indirectly through retention of earnings (retained earnings being the portion of funds which are earned as profits but not paid out as ownership dividends). This is about 8% of assets.
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The Bank Balance Sheet: Liabilities (d) Since assets minus liabilities equals capital, capital is seen as protecting the liability suppliers from asset devaluations or writeoffs (capital is also called the balance sheets shock absorber, thus capital levels are important).

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The Bank Balance Sheet: Assets (a) Reserves: funds held in account with the Fed (vault cash as well). Required reserves represent what is required by law under current required reserve ratios. Any reserves beyond this area called excess reserves.

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The Bank Balance Sheet: Assets (a) Cash items in Process of Collection: checks deposited at a bank, but where the funds have not yet been transferred from the other bank. Deposits at Other Banks: usually deposits from small banks at larger banks (referred to as correspondent banking)

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The Bank Balance Sheet: Assets (a) Reserves, Cash items in Process of Collection, and Deposits at Other Banks are collectively referred to as Cash Items in our balance sheet, and account for 2% of assets.

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The Bank Balance Sheet: Assets (b) Securities: these are either U.S. government/agency debt, municipal debt, and other (non-equity) securities. These make-up about 17% of assets. Short-term Treasury debt is often referred to as secondary reserves because of its high liquidity.

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The Bank Balance Sheet: Assets (c) & (d) Loans: representing 74% of assets, these are a banks income-earning assets, such as business loans, auto loans, and mortgages. These are generally not very liquid. Most banks tend to specialize in either consumer loans or business loans, and even take that as far as loans to specific groups (such as a particular industry). Other Assets: bank buildings, computer systems, and other equipment.
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Basics of Banking
Before we explore the main role of banks that is, asset transformationit is helpful to understand some of the simple accounting associated with the process of banking. But think beyond the debits/credit and try to see that banks engage in asset transformation.

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Basics of Banking
Asset transformation is, for example, when a bank takes your savings deposits and uses the funds to make, say, a mortgage loan. Banks tend to borrow short and lend long (in terms of maturity).

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Basics of Banking
T-account Analysis:
Deposit of $100 cash into First National Bank

First National Bank

Assets Vault cash +$100 Liabili ties Checkable deposits +$100

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Basics of Banking
Deposit of $100 check
First National Bank
Assets Cash items in process of collection +$100 Liabili ties Checkable deposits +$100

First National Bank

Assets Reserves +$100 Liabilities Deposits +$100

Second National Bank

Assets Reserves -$100 Liabili ties Deposits -$100

Conclusion: When bank receives deposits, reserves by equal amount; when bank loses deposits, reserves by equal amount
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Basics of Banking
This simple analysis gets more complicated when we add bank regulations to the picture. For example, if we return to the $100 deposit, recall that banks must maintain reserves, or vault cash. This changes how the $100 deposit is recorded.

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Basics of Banking
T-account Analysis:
Deposit of $100 cash into First National Bank

First National Bank

Assets Required reserves +$10 Excess reserves +$90 Liabilities Checkable deposits +$100

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Basics of Banking
As we can see, $10 of the deposit must remain with the bank to meeting federal regulations. Now, the bank is free to work with the $90 in its asset transformation functions. In this case, the bank loans the $90 to its customers.

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Basics of Banking
T-account Analysis:
Deposit of $100 cash into First National Bank

First National Bank

Assets Required reserves +$10 Loans +$90 Liabilities Checkable deposits +$100

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General Principles of Bank Management

Now lets look at how a bank manages its assets and liabilities. The bank has four primary concerns: 1. Liquidity management 2. Asset management
Managing credit risk Managing interest-rate risk

3. Liability management 4. Managing capital adequacy

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General Principles of Bank Management Although we will focus on these ideas, banks must also manage credit risk and interest-rate risk.
Subjects covered in FNCE 4000

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Principles of Bank Management

Liquidity Management
Reserves requirement = 10%, Excess reserves = $10 million Assets Reserves Loans Securities $20 million Deposits $80 million Bank Capital $10 million Liabili ties $100 million $10 million

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Principles of Bank Management

Deposit outflow of $10 million
Assets Reserves Loans Securities $10 million Deposits $80 million Bank Capital $10 million Liabili ties $90 million $10 million

With 10% reserve requirement, bank still has excess reserves of $1 million: no changes needed in balance sheet
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Liquidity Management
No excess reserves
Assets Reserves Loans Securities
Assets Reserves Loans Securities $0 million Deposits $80 million Bank Capital $10 million

Liabili ties $10 million Deposits $90 million Bank Capital $10 million
Liabili ties $90 million $10 million

$100 million $10 million

Deposit outflow of $10 million

With 10% reserve requirement, bank has $9 million reserve shortfall

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Liquidity Management
1. Borrow from other banks or corporations
Assets Reserves Loans Securities Liabili ties $9 million Deposits $90 million Borrowings $10 million Bank Capital $100 million $90 million $9 million $10 million

2. Sell securities
Assets Reserves Loans Securities Liabili ties $9 million Deposits $90 million Bank Capital $1 million
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$90 million $10 million

Liquidity Management
1. Borrowing from banks = Fed Funds
Assets Reserves Loans Securities $9 million Deposits $90 million Fed Funds $10 million Bank Capital Liabilities $100 million $9 million $10 million

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Liquidity Management
3. Borrow from Fed
Assets Reserves Loans Securities Liabilities $9 million Deposits $90 million Discount Loans $10 million Bank Capital $90 million $9 million $10 million

4. Call in or sell off loans

Assets Reserves Loans Securities Liabili ties $9 million Deposits $81 million Bank Capital $10 million $90 million $10 million

Conclusion: Excess reserves are insurance against above 4 costs from deposit outflows
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Asset Management
Asset Management: the attempt to earn the highest possible return on assets while minimizing the risk.
1. Get borrowers with low default risk, paying high interest rates 2. Buy securities with high return, low risk

3. Diversify
4. Manage liquidity
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Liability Management
Liability Management: managing the source of funds, from deposits, to CDs, to other debt.
1. Important since 1960s 2. No longer primarily depend on deposits 3. When see loan opportunities, borrow or issue CDs to acquire funds

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Capital Adequacy Management

1. Bank capital is a cushion that prevents bank failure. For example, consider these two banks:
High Capital Bank
Assets Reserves Loans Liabilities $10 million Deposits $90 million Bank Capital $90 million $10 million

Low Capital Bank

Assets Reserves Loans Liabilities $10 million Deposits $90 million Bank Capital $96 million $4 million

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Capital Adequacy Management

What happens if these banks make loans or invest in securities (say, subprime mortgage loans, for example) that end up losing money? Lets assume both banks lose $5 million from bad loans.

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Capital Adequacy Management

Impact of $5 million loan loss
High Capital Bank
Assets Reserves Loans Liabilities $10 million Deposits $85 million Bank Capital $90 million $5 million

Low Capital Bank

Assets Reserves Loans Liabilities $10 million Deposits $85 million Bank Capital $96 million -$1 million

Conclusion: A bank maintains capital to lessen the chance that it will become insolvent.
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Capital Adequacy Management

So, why dont banks hold want to hold a lot of capital?? 2. Higher is bank capital, lower is return on equity
ROA = Net Profits/Assets ROE = Net Profits/Equity Capital EM = Assets/Equity Capital ROE = ROA EM Capital , EM , ROE

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Capital Adequacy Management

3. Tradeoff between safety (high capital) and ROE 4. Banks also hold capital to meet capital requirements (more on this in Chapter 20).

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The Practicing Manager:

Strategies for Managing Capital: what should a bank manager do if she feels the bank is holding too much capital?
Sell or retire stock Increase dividends to reduce retained earnings

Increase asset growth via debt (like CDs)

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The Practicing Manager:

Reversing these strategies will help a manager if she feels the bank is holding too little capital?
Issue stock Decrease dividends to increase retained earnings

Slow asset growth (retire debt)

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The Capital Crunch and the Credit Crunch in the early 1990s Did the capital crunch cause the credit crunch in the early 1990s?
In 1990 and 1991 credit growth slowed to an extremely low pace Our analysis suggests that a capital crunch was a likely cause. Loan losses in the late 80s and an increase in capital requirements immediately preceded this period.

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The Capital Crunch and the Credit Crunch in the early 1990s Did the capital crunch cause the credit crunch in the early 1990s?
Banks were forced to either (1) raise new capital or (2) reduce lending. Guess which route they chose?

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Off-Balance-Sheet Activities
1. 2.

Loan sales (secondary loan participation) Fee income from

Foreign exchange trades for customers Servicing mortgage-backed securities Guarantees of debt Backup lines of credit

3.

Trading Activities and Risk Management Techniques

1. 2. 3. Financial futures and options Foreign exchange trading Interest rate swaps

All these activities involve risk and potential conflicts

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Rogue Traders
To highlight the problems that some of these off-balance sheet activities generate, we will briefly look at two incidences with devastating results. Barings: Nick Leeson engaged in speculative trades on the Nikkea, and personally generated $1.3 billion in losses over a 3-year period. Barings had to close!
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Rogue Traders
Daiwa Bank: Toshihide Iguchi racked up $1.1 billion in losses in trading. When he fessed-up, the bank decided to hide this from regulators. The bank was eventually fined $340 million and barred from U.S. operations.

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Measuring Bank Performance

Much like any business, measuring bank performance requires a look at the income statement. For banks, this is separated into three parts:
Operating Income
Operating Expenses Net Operating Income

Note how this is different from, say, a manufacturing firms income statement.
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Banks' Income Statement

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Measuring Bank Performance

As, much like any firm, ratio analysis is useful to measure performance and compare performance among banks. The following slide shows both calculations and historical averages for key bank performance measures.

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Recent Trends in Bank Performance Measures

ROA = Net Profits/ Assets ROE = Net Profits/ Equity Capital

NIM = [Interest Income Interest Expenses]/ Assets

Chapter Summary
The Bank Balance Sheet: we reviewed the basic assets, liabilities, and bank capital that make up the balance sheet Basics of Banking: we examined the accounting entries for a series of simple bank transactions

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Chapter Summary (cont.)

General Principles of Bank Management: we discussed the roles of liability, reserves, asset, and capital adequacy management for a bank Off-Balance Sheet Activities: we briefly reviewed some of the (risky) activities that banks engage in that dont appear on the balance sheet or income statement
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Chapter Summary (cont.)

Measuring Bank Performance: we reviewed the income statement for a banking organization and key ratios commonly used for measuring and comparing bank performance

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